Did Bennett McCallum run the SNB for the last 20 years?

Which central bank has conducted monetary policy in the best way in the last five years? Among “major” central banks the answer in my view clearly would have to be the SNB – the Swiss central bank.

Any Market Monetarist would of course tell you that you should judge a central bank’s performance on it’s ability to deliver nominal stability – for example hitting an nominal GDP level target. However, for an small very open economy like the Swiss it might make sense to look at Nominal Gross Domestic Demand (NGDD).

This is Swiss NGDD over the past 20 years.

NGDD Switzerland

Notice here how fast the NGDD gap (the difference between the actual NGDD level and the trend) closed after the 2008 shock. Already in 2010 NGDD was brought back to the 1993-trend and has since then NGDD has been kept more or less on the 1993-trend path.

Officially the SNB is not targeting NGDD, but rather “price stability” defined as keeping inflation between 0 and 2%. This has been the official policy since 2000, but at least judging from the actually development the policy might as well have been a policy to keep NGDD on a 2-3% growth path. 

Bennett McCallum style monetary policy is the key to success

So why have the SNB been so successful?

My answer is that the SNB – knowingly or unknowingly – has followed Bennett McCallum’s advice on how central banks in small open economies should conduct monetary policy. Bennett has particularly done research that is relevant to understand how the SNB has been conducting monetary policy over the past 20 years.

First, of all Bennett is a pioneer of NGDP targeting and he was recommending NGDP targeting well-before anybody ever heard of Scott Summer or Market Monetarism.  A difference between Market Monetarists and Bennett’s position is that Market Monetarists generally recommend level targeting, while Bennett (generally) has been recommending growth targeting.

Second, Bennett has always forcefully argued that monetary policy is effective in terms of determining NGDP (or NGDD) also when interest rates are at zero and he has done a lot of work on optimal monetary policy rules at the Zero Lower Bound (See for example here). One obvious policy is quantitative easing. This is what Bennett stressed in his early work on NGDP growth targeting.  Hence, the so-called Mccallum rule is defined in terms the central bank controlling the money base to hit a given NGDP growth target. However, for small open economies Bennett has also done very interesting work on the use of the exchange rate as a monetary policy tool when interest rates are close to zero.

I earlier discussed what Bennett has called a MC rule. According to the MC rule the central bank will basically use interest rates as the key monetary policy rule. However, as the policy interest rate gets close to zero the central bank will start giving guidance on the exchange rate to change monetary conditions. In his models Bennett express the policy instrument (“Monetary Conditions”) as a combination of a weighted average of the nominal exchange rate and a monetary policy interest rate.

SNB’s McCallum rule

My position is that basically we can discribe SNB’s monetary policy over the past 20 years based on these two key McCallum insights – NGDP targeting and the use of a combination of interest rates and the exchange rate as the policy instrument.

To illustrate that I have estimated a simple OLS regression model for Swiss interest rates.

It turns out that it is very to easy to model SNB’s reaction function for the last 20 years. Hence, I can explain 85% of the variation in the Swiss 3-month LIBOR rate since 1996 with only two variables – the nominal effective exchange rate (NEER) and the NGDD gap (the difference between the actual level of Nominal Gross Domestic Demand and the trend level of NGDD). Both variables are expressed in natural logarithms (ln).

The graph below shows the actually 3-month LIBOR rate and the estimated rate.

SNB policy rule

As the graph shows the fit is quite good and account well for the ups and down in Swiss interest rates since 1996 (the model also works fairly well for an even longer period). It should be noted that I have done the model for purely illustrative purposes and I have not tested for causality or the stability of the coefficients in the model. However, overall I think the fit is so good that this is a pretty good account of actual Swiss monetary policy in the last 15-20 years.

I think it is especially notable that once interest rates basically hit zero in early 2010 the SNB initially started to intervene in the currency markets to keep the Swiss franc from strengthening and later – in September 2011 – the SNB moved to put a floor under EUR/CHF at 120 so to completely curb the strengthening of Swiss franc beyond that level. As a result the nominal exchange rate effectively has been flat since September 2011 (after an initial 10% devaluation) despite massive inflows to Switzerland in connection with the euro crisis and rate of expansion in the Swiss money supply has accelerated significantly.

Concluding, Swiss monetary policy has very much been conducted in the spirit of Bennett McCallum – the SNB has effectively targeted (the level of) Nominal Gross Domestic Demand and SNB has effectively used the exchange rate instrument to ease monetary conditions with interest rates at the Zero Lower Bound.

The result is that the Swiss economy only had a very short period of crisis in 2008-9 and the economy has recovered nicely since then. Unfortunately none of the other major central banks of the world have followed the advice from Bennett McCallum and as a result we are still stuck in crisis in both Europe and the US.

PS I am well-aware that the discuss above is a as-if discussion that this is what the SNB has actually said it was doing, but rather that it might as well been officially have had a McCallum set-up.  

PPS If one really wants to do proper econometric research on Swiss monetary policy I think one should run a VAR model on the 3-month LIBOR rate, the NGDD gap and NEER and all of the variables de-trended with a HP-filter. I will leave that to somebody with econometric skills and time than myself. But I doubt it would change much with the conclusions.

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Bennett McCallum told “my” Kuroda story a decade ago

From to time I will make an argument and then later realize that it really wasn’t my own independently thought out argument, but rather a “reproduction” of something I once read. Often it would be Milton Friedman who has been my inspiration, however, Friedman is certainly not my only inspiration.

Another economist who undoubtedly have had quite a bit of an influence on my thinking is Bennett McCallum and guess what – it turns out that the argument that I was making in my latest post on the “Kuroda recovery” is very similar to the type of argument Bennett made in a number of papers around a decade ago about how to get Japan out of the deflationary trap. Bennett has kindly pointed this out to me. I know Bennett’s work on Japan quite well, but when I was writing my post yesterday I didn’t realize how close my thinking was to Bennett’s arguments.

I therefore think it is appropriate to touch on some of Bennett’s main conclusions and how they relate to the situation in Japan today.

I my previous post I argued that easing of monetary policy in Japan would primarily work through an increase in domestic demand – contrary to the general perception that monetary easing would primarily boost exports through a depreciation of the yen. Bennett told the exact same story a decade ago in his paper “Japanese Monetary Policy, 1991–2001″ (and a number of other papers).

While I used general historical observations to make my argument Bennett in his 2003 paper uses a formal model. His model is a variation of an open economy DSGE model calibrated for the Japanese economy originally developed with Edward Nelson.

In his paper Bennett simulates a shock to inflation expectations – from -1% inflation to +1% inflation. Hence, this is not very different from the actual shock we are presently seeing in Japan. However, while the “Kuroda-shock” is a direct shock to the money base in Bennett’s example the exchange rate is used as the policy instrument.  However, this is not really important for the results in the model (as far as I can see at least…).

In Bennett’s model the Bank of Japan is buying foreign assets to weaken the yen to increase inflation expectations. According to the general perception this should lead to an marked improvement Japanese net exports. However, take a look at what conclusion Bennett reaches:

The variable on whose response we shall focus is the home country’s— i.e., Japan’s—net export balance in real terms….we see that the upward jump in the target inflation rate (π), which occurs in period 1, does indeed induce an exchange-rate depreciation rate that remains positive for over two years. Inflation, not surprisingly, rises and stays above its initial value for over two years, then oscillates and settles down at a new steady state rate of 0.005 (in relation to its starting value). Quite surprisingly, p responds more strongly than s so the real exchange rate appreciates. As expected, however, real output rises strongly for two years.

Most importantly, the real (Japanese) export balance is so affected by the two-year increase in real output that it turns negative and stays negative for almost two years.

Hence, Bennett’s simulations shows the same result as i postulated in my previous post – that monetary easing even if it leads to a substantial weakening of the yen will primarily boost domestic demand. In fact it is likely that after a few quarters the boost to domestic demand will lead to higher import growth than export growth and hence the net impact on the Japanese trade balance is likely to be negative.

Said, in another way there is no beggar-thy-neighbor-effect. In fact is anything monetary easing in Japan is likely to boost exports to Japan rather than the opposite.

I am sure that Bennett’s papers also in the future will inspire me to write blog posts on different topics as anybody who follow my blog knows it has done in the past – even when I don’t realize myself to begin with. Until then I suggest to my readers that you take a look at Bennett’s 2003 paper. It will teach you quite a bit about what is happening in Japan a decade after Bennett wrote the paper.

The RBA just reminded us about the “Export Price Norm”

In my view one of the key reasons that Australia avoided recession in 2008-9 was the Reserve Bank of Australia (RBA) effectively is operating what I earlier have called a “Export Price Norm”. Here is what I earlier had to say about that:

One of the reasons why I think the RBA has been relatively successful is that it effectively has shadowed a policy of what Jeff Frankel calls PEP (Peg the currency to the Export Price) and what I (now) think should be called an “Export Price Norm” (EPN). EPN is basically the open economy version of NGDP level targeting.

If the primary factor in nominal demand changes in the economy is exports – as it tend to be in small open economies and in commodity exporting economies – then if the central bank pegs the price of the currency to the price of the primary exports then that effectively could stabilize aggregate demand or NGDP growth. This is in fact what I believe the RBA – probably unknowingly – has done over the last couple of decades and particularly since 2008. As a result the RBA has stabilized NGDP growth and therefore avoided monetary shocks to the economy.

Under a pure EPN regime the central bank would peg the exchange rate to the export price. This is obviously not what the RBA has done. However, by it’s communication it has signalled that it would not mind the Aussie dollar to weaken and strengthen in response to swings in commodity prices – and hence in swings in Australian export prices. Hence, if one looks at commodity prices measured by the so-called CRB index and the Australian dollar against the US dollar over the last couple of decades one would see that there basically has been a 1-1 relationship between the two as if the Aussie dollar had been pegged to the CRB index. That in my view is the key reason for the stability of NGDP growth over the past two decade. The period from 2004/5 until 2008 is an exception. In this period the Aussie dollar strengthened “too little” compared to the increase in commodity prices – effectively leading to an excessive easing of monetary conditions – and if you want to look for a reason for the Australian property market boom (bubble?) then that is it.

This morning the RBA had it regular monetary policy meeting and see here what the bank had to say:

“The inflation outlook, as assessed at present, would afford scope to ease policy further, should that be necessary to support demand…On the other hand the exchange rate remains higher than might have been expected, given the observed decline in export prices”

This is a pretty clear restatement of the “export price norm” (“the exchange rate remains higher than might have been expected, given the observed decline in export prices”). Note also the wording “support demand”. “Demand” is basically an other word for nominal GDP.

So yes, the RBA did not cut interest rates, but it has used the market and particularly the exchange rate channel to ease monetary conditions. This is pretty much in line with Bennett McCallum’s suggestion that small open-economies that operate monetary policy with interest rates close to zero should utilize the exchange rate as a policy instrument. This is what McCallum has called the MC rule.

So effectively – the RBA is indirectly targeting NGDP and seems to pretty well understand the McCallum’s MC rule as it continues to utilize the “Export Price Norm”. So Australia is hardly my biggest worry at the moment.

Imagine the FOMC had listened to Al Broaddus in 2003

In my recent post on how the central banks of Australia, Poland and Sweden should have a look at Bennett McCallum’s MC rule I briefly mentioned how Richmond fed president Al Broaddus already back in 2003 warned that the Federal Reserve should have a plan for how to conduct monetary policy at the the “Zero Lower Bound”. It was of course Bob Hetzel’s brilliant book on the Great Recession that inspired me. In his book Bob quotes Broaddus’ comments at the June 24-25 2003 FOMC meeting.

Here is Broaddus (my bold):

With respect to our strategy and tactics going forward—trying to apply some of the lessons from history and even looking beyond them—I recognize that we may be able to address further disinflation by inducing significant additional reductions in long-term interest rates whether we explicitly target them or not. That’s what most people seem to be thinking about as the next step. But I’d like to add a new dimension to this discussion because bond rates, like short rates, are also subject to a zero bound at some point, which ultimately would put a limit on this policy channel if disinflation persisted or deflation began to threaten us. So I’d like to talk about what I’ll refer to as the “what next” issue for a couple of minutes. That issue is, How should we think about further monetary stimulus if we get to the point where both long- and short-term interest rate policies essentially have been immobilized?

Now, I agree with a lot of other people—although I’m not sure how many people around the table here—that the odds we will face this situation are small and may be exceedingly small. Because of that, it’s tempting to conclude that we have plenty of time and really don’t need to think about this or discuss it yet. In other words, we’ll cross that bridge when we get to it. But I would argue that it’s not only useful but actually urgent that we think about these kinds of options now. I’m building on the point you were making, Cathy, because confronting deflation just like confronting inflation involves a credibility problem. That’s the essence of it for me. Moreover, unlike inflation, the credibility problem in dealing with deflation is compounded by the zero bound on nominal interest rates. That raises at least the possibility that interest rate policy alone can’t deter deflation even if we’re willing to drive both short- and long-term interest rates to zero.

In the current situation—I’m not going to talk about current policy but use that as a framework in this situation—if the funds rate were to get closer to zero, the possibility of deflation has the potential to create deflation expectations and actual deflation simply because people may doubt that we can and will use monetary policy to combat deflation effectively at the zero bound. My concern is that waiting to say or think about how we would deliver further monetary stimulus if rates were to fall to zero could in some circumstances lead the public to conclude that we can’t do it.If people think we can’t deliver, that would risk creating a credibility deficit that could make it much more difficult to deal with this situation if in fact it arises and we try to use different types of policies to deal with it. So that’s why I think it’s essential that we begin to talk about this and consider it now. I’m not talking about developing a detailed strategy but at least putting something on the table.

Let me quickly recapitulate the key points I’ve tried to make here. The first is that, until we work through this “what next” scenario and communicate a credible strategy, addressing it to the public at some point, I think our contingency plans for confronting deflation will be incomplete. In my view, that would be a serious omission. We do a lot of contingency planning at the Fed, and I believe we should do some comprehensive contingency planning on this kind of scenario even if its probability is low. And I would say the sooner the better. We don’t have a stash of credibility as deflation fighters yet. If we delay thinking about and developing a strategy for dealing with further disinflation and it continues—and especially if it accelerates—we could wind up with a sizable credibility deficit.That could make it very difficult for us to employ successfully any strategy that we might be forced to come up with in this kind of situation. So I would just put that view on the table, too.

Today we can only imagine how the world would have looked if the FOMC had listened to Broaddus’ suggestions and put in place “contingency planning” to avoid crisis if the fed funds rate hit the zero lower bound. The FOMC unfortunately failed to do so – and so did the ECB, the Bank of England, the Bank of Japan and basically every single central bank in the world – maybe with the exception of the Monetary Authority in Singapore.

However, it is not to late for other central banks in the world to put in place contingency plans to “automatically prevent” disaster at the zero lower bound. Are you listening in Stockholm, Warsaw and Sydney? In Prague? (I have given up on Frankfurt…)

Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

Guest blog: Growth or level targeting? (by David Eagle)

We continue the series of guest blogs by David Eagle on his research on NGDP targeting and related topics.

See also David’s first guest post “Why I Support NGDP Targeting”.

Enjoy the reading.

Lars Christensen

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Guest blog: Growth vs. level targeting

by David Eagle

In my first guest blog for “The Market Monetarist” I stated that I am in favor of targeting the level of Nominal GDP (NGDP) and not the growth rate of NGDP.  Some economists such as Bennett McCallum (2011) are in favor of NGDP-growth-rate targeting (ΔNT) over NGDP Targeting (NT).

I have long opposed inflation targeting (IT) and I view ΔNT as almost as bad as IT because both cause what we call negative NGDP base drift. In order to understand my arguments against ΔNT and against IT, we need to understand the concepts of NGAP and NGDP base drift.

In this blog, I use an example to illustrate these concepts and the difference between NT and ΔNT.  It also uses another example to help us understand the concepts of PGAP and price-level base drift, and the difference between price-level targeting (PLT) and IT.

Growth vs. Level NGDP Targeting

To see the similarities and differences between targeting the growth rate of NGDP (ΔNT) and the level of NGDP (NT), assume the central bank’s target for NGDP growth  would be 5%.  As long as the central bank (CB) meets that target, NGDP would follow the path Nt = N0 (1.05)t where N0 is the NGDP for the base year and Nt is the NGDP occurring t years after the base year.

For consistency, assume that the CB’s target for NGDP (if it targets the NGDP level) would be Nt* = N0 (1.05)t.  Hence, as long as the central bank meets its target, then NGDP will be the same whether the central bank targets the growth rate or the level of NGDP.

The difference between growth rate targeting and level target occurs when the central bank misses its target.  Assume for example N0 = 10.  Initially, both NT and ΔNT have the same intended NGDP trajectory of Nt = 10(1.05)t; in particular, both NT and ΔNT aim for N1 to be 10.5.  However, assume the central bank misses its target and N1 = 10.08, which is 4% below its targeted level of NGDP.  We define NGAPt as the percent deviation at time t of NGDP from its previous trend; hence in this example NGAP1 = -4%.  Under NT, the central bank will try to make up for lost ground to reduce NGAP to zero and return NGDP back to its targeted path of Nt = 10(1.05)t.

In contrast, under NGDP growth targeting, the central bank will only try to meet its targeted NGDP growth rate of 5% in the future. Hence, under NGDP growth targeting, the central bank will shift its NGDP trajectory to Nt = 10.08(1.05)t-1, which is 4% below the initial NGDP trajectory of Nt = 10(1.05)t. In other words, under NGDP growth targeting, the central bank would let the 4% NGAP continue indefinitely. NGDP base drift occurs when the central bank allows NGAP to continue rather than trying to eliminate that NGAP in the future.

Price Level Targeting vs. Inflation Targeting

The concept of NGDP base drift is related to the concept “price-level base drift,” which many economists such as Svensson (1996) and Kahn (2009) have long recognized to be the theoretical difference between price-level targeting (PLT) and inflation targeting (IT).

In particular, Mankiw (2006) states, “The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes,” while Taylor (2006) states, “Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise [or fall] in the price level” [brackets added].

Also, Meh, et al (2008) state, “Under IT, the central bank does not bring the price level back and therefore the price level will remain at its new path after the shock.” They go on to say that under PLT, “the central bank commits to bringing the price level back to its initial path after the shock.”

To see the similarities and differences between PLT and IT, assume the central bank’s target for inflation (if it follows IT) would be 2%.  Then the CB’s trajectory for the price level will be Pt = P0 (1.02)t where P0 is the price level for the base year and Pt is the price level occurring t years after the base year.  Similarly assume that the central bank’s price-level target (if it follows PLT) would be Pt* = P0 (1.02)t.  Hence, when the central bank meets its target, the price level will be the same regardless if the central bank follows PLT or IT.

The difference between PLT and IT occurs when the central bank misses its target.  For this example, assume P0 = 100.  Initially, both PLT and IT have the same price-level trajectory of Pt = 100(1.02)t.  In particular, under both PLT and IT, the CB is aiming for Pt  to be 102 at time t=1.  However, assume that the central bank misses its target and Pt = 100.47, which is 1.5% less than its targeted price level of 102.  We define PGAPt to be the percent deviation of the price level at time t from its previous trend; hence, in this example; PGAP1 = ‑1.5%.

Under PLT, the central bank will try to return PGAP back to zero by increasing the price-level back up to its targeted price-level path of Pt = 100 (1.02)t.  Under IT, the central bank will “let bygones be bygones” and merely try to meet its inflation target of 2% in the future.  Hence, under IT, the central bank shifts its price-level trajectory to Pt = 100.47 (1.02)t-1, which is 1.5% below its initial trajectory.  In other words, the central bank lets the -1.5% PGAP continue into the foreseeable future.  Price-level base drift occurs when the central bank allows PGAP to continue rather than trying to eliminate that PGAP in the future.

Price-level base drift implies NGDP base drift

Because IT leads to price-level base drift, it also leads to NGDP base drift.  To illustrate with an example, assume the long-run growth rate in real GDP (RGDP) is 3% and RGDP in the base year is Y0 = 10 trillion dollars.  Therefore, when the central bank expects RGDP to grow at its long-run growth rate, it expects Yt = 10(1.03)t.

Initially in this example when the central bank has a 2% inflation target, the central bank’s trajectory for the price level under inflation targeting is Pt = 100 (1.02)t.  Since Nt=PtYt/100 when we use 100 as the price level in the base year, this means that the CB’s trajectory for NGDPt is Nt = 10 (1.02)t(1.03)t.  When it turned out that P1 was 100.47 instead of 102, the central bank following IT would shift its price level trajectory to Pt = 100.47 (1.02)t-1 and its NGDP trajectory to Nt = 10.047 (1.02)t-1(1.03)t, which is 1.5% below its initial NGDP trajectory.  Therefore, NGAP under this trajectory will be -1.5%, which means a negative NGDP base drift.

“Inflation targeting” can be many things

In practice, inflation targeting is not as simple as I described above or even as several of the economists I quoted described it.   In practice, central banks following inflation targeting target a long-run rather than a short-run inflation rate.  They also try to target “core inflation” rather than general inflation.  Also, they do consider output gap and unemployment as well as inflation.  Therefore, the question whether IT in practice leads to NGDP base drift is primarily an empirical one.

According to my empirical research that I plan to report in a later blog, past U.S. monetary policy has on average resulted in a significant negative NGDP base drift.  Also, that research indicates that the primary reason for the prolonged high unemployment following a recession is this negative NGDP base drift.

References:

Kahn, George A. (2009). “Beyond Inflation Targeting: Should Central Banks Target the Price Level?” Federal Reserve Bank Of Kansas City Economic Review (Third quarter), http://www.kansascityfed.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf

Mankiw, Greg (2006). “Taylor on Inflation Targeting,” Greg Mankiw’s Blog (July 13) http://gregmankiw.blogspot.com/2006/07/taylor-on-inflation-targeting.html

McCallum, Bennett, “Nominal GDP Targeting” Shadow Open Market Committee, October 21, 2011, http://shadowfed.org/wp-content/uploads/2011/10/McCallum-SOMCOct2011.pdf

Meh, C. A., J.-V. Ríos-Rull, and Y. Terajima (2008). “Aggregate and Welfare Effects of Redistribution of Wealth under Inflation and Price-Level Targeting.” Bank of Canada Working Paper No. 2008-31, http://www.econ.umn.edu/~vr0j/papers/cvyjmoef.pdf

Svensson, Lars E. O. (1996). “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” NBER Working Paper 5719, http://www.nber.org/papers/w5719.pdf, accessed on January 4, 2012.

Taylor, John (2006). “Don’t Talk the Talk: Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level.” The Economist (July 13), http://online.wsj.com/article/SB115275691231905351.html?mod=opinion_main_commentaries

© Copyright (2012) David Eagle


Exchange rate based NGDP targeting for small-open economies

The debate about NGDP targeting is mostly focused on US monetary policy and the focus of most of the Market Monetarist bloggers is on the US economy and on US monetary policy. That is not in anyway surprising, but this is of little help to policy makers in small-open economies and I have long argued that Market Monetarists also need to address the issue of monetary policy in small-open economies.

In my view NGDP level targeting is exactly as relevant to small-open economies as for the US or the euro zone. However, it terms of the implementation of NGDP level targeting in small open economies that might be easier said than done.

A major problem for small-open economies is that their financial markets typically are less developed than for example the US financial markets and equally important exchange rates moves is having a much bigger impact on the overall economic performance – and especially on the short-term volatility in prices, inflation and NGDP. I therefore think that there is scope for thinking about what I would call exchange rate based NGDP targeting in small open economies.

What I suggest here is something that needs a lot more theoretical and empirical work, but overall my idea is to combine Irving Fisher’s compensated dollar plan (CDP) with NGDP level targeting.

Fisher’s idea was to stabilise the price level by devaluing or revaluing the currency dependent on whether the actual price level was higher or lower than the targeted price level. Hence, if the price level was 1% below the target price level in period t-1 then the currency should devalued by 1% in period t. The Swedish central bank operated a scheme similar to this quite successfully in the 1930s. In Fisher’s scheme the “reference currency” was the dollar versus gold prices. In my scheme it would clearly be a possibility to “manage” the currency against some commodity price like gold prices or a basket of commodity prices (for example the CRB index). Alternatively the currency of the small open economy could be managed vis-à-vis a basket of currencies reflecting for example a trade-weighted basket of currencies.

Unlike Fisher’s scheme the central bank’s target would not be the price level, but rather a NGDP path level and unlike the CDP it should be a forward – and not a backward – looking scheme. Hence, the central bank could for example once every quarter announce an appreciation/depreciation path for the currency over the coming 2-3 years. So if NGDP was lower than the target level then the central bank would announce a “lower” (weaker) path for the currency than otherwise would have been the case.

For Emerging Markets where productivity growth typical is higher than in developed markets the so-called Balassa-Samuelson effect would say that the real effective exchange rate of the Emerging Market economy should gradually appreciate, but if NGDP where to fall below the target level then the central bank would choose to “slowdown” the future path for the exchange rate appreciation relative to the trend rate of appreciation.

I believe that exchange rate based NGDP level targeting could provide a worthwhile alternative to floating exchange (with inflation or NGDP targeting) or rigid pegged exchange rate policies. That said, my idea need to be examined much closer and it would be interesting to see how the rule would perform in standard macroeconomic models under different assumptions.

Finally it should be noted that the there are some clear similarities to a number for the proposal for NGDP growth targeting Bennett McCallum has suggested over the years.

Does China target NGDP?

Much of the debate about NGDP targeting in the blogosphere is about what the Federal Reserve should do. However, I think it is equally important to discuss and focus on what monetary regimes are preferable for other countries. I hope I will be able to increase the focus among Market Monetarists on monetary policy in other countries than the US.

Given that China is the second largest economy is the world it is somewhat surprising how little interest their is in Chinese monetary policy and especially in what are the key drivers of Chinese monetary policy. A working paper - “McCallum rule and Chinese monetary policy” – by Tuuli Koivu, Aaron Mehrotra and Riikka Nuutilainen from 2008 sheds more light on this important topic and Market Monetarists should be very interested in the results.

Here is the abstract:

“This paper evaluates the usefulness of a McCallum monetary policy rule based on money supply for maintaining price stability in mainland China. We examine whether excess money relative to rule-based values provides information that improves the forecasting of price developments. The results suggest that our monetary variable helps in predicting both consumer and corporate goods price inflation, but the results for consumer prices depend on the forecasting period. Nevertheless, growth of the Chinese monetary base has tracked the McCallum rule quite closely. Moreover, results using a structural vector autoregression suggest that our measure of excess money supply could be used to identify monetary policy shocks in the Chinese economy.”

Hence, according to the authors the People’s Bank of China (PBoC) follow a McCallum rule whereby they use the money base to hit a given target for growth in nominal GDP (NGDP).

This in my view is a highly interesting result and it is somewhat of a surprise that these empirical results have not gotten more attention – especially given China’s impressive economic performance in recent years. Furthermore, it would be extremely interesting to see how the results would look if they where updated to include the Great Recession period. I am sure there is lot of aspiring Market Monetarists out there who are getting ready to update these results…

The PBoC is certainly not conducting monetary policy in a transparent way and the Chinese financial markets remain overly regulated, but at least it seems like the PBoC got their money base control more or less right.

Bennett McCallum on EconPapers – start downloading NOW!

In a post today Scott Sumner pays tribute to Bennett McCallum. I am as Scott is a big fan of Dr. McCallum (and of Scott).

I have promised to do some posts on Dr. McCallum’s huge work on Nominal Income Targeting (NIT). I am particularly interested his work on NIT in small open economies, but it is all worth reading.

I suggest anybody interested in Dr. McCallum’s work starts at EconPapers. Take a look here and start downloading. I welcome anybody who would like to do guest blogs on their reading of Dr. McCallum’s work.

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